Investing, in simple terms, is about figuring out two things:
- The depth of competitive advantage enjoyed by the company, if there’s any.
- Based on (i) above, trying to come up with a conservative estimate of its value in light of the business landscape 5-10 years from now
Or this was what I used to think before I came across this quote by Buffett –
“After ten years on the job, a CEO whose company annually retains earnings equal to 10% of net worth will have been responsible for the deployment of more than 60% of all the capital at work in the business.”
Why is it more often ignored?
The shorter investing horizon which most of the investors (read as speculators) employ make them oblivious to capital allocation and management’s temperament. Actions of the same company managed by same set of guys receives different interpretations from different investors depending upon from where do they belong.
Different horizons make interpretations go haywire. Take Valeant for example. They were acquiring brands and improving its margins. Near term, quantitative assessment would put them as ‘turnaround specialist’ or even as ‘bargain investors’ glorifying what they were doing. But a closer look would reveal that they were rapidly taking on debt and hiking up drug prices. Also, their frequency of going out for an acquisition was a bit scary.
If you had a 2-3 year horizon, you would have liked the immediate gratification which shareholders were blessed with by such aggressive moves of the management. Whereas, if you employed an owner like mind-set (thinking as if you buying 100% of the business possibly to own for next decade or so) those drug price hikes and ever increasing leverage would have seemed scary.
Why is it necessary?
For someone planning to hold a concentrated portfolio with longer time horizon and employ an owner-like mindset to investing as I plan to, ignoring management assessment just because it isn’t as black and white as we expect doesn’t make any sense.
Even for someone who uses a shorter horizon to invest (< 3 years), ignoring management quality may not serve him well over his investing lifetime. Valeant is not just one singular example. Investing mistakes are filled with such kind of thrash.
Following are some points why I feel its indispensable:
- Capital Allocation: Need I say more? Buffett has said it so clearly. What management does today with our moneys will decide how much would we earn as owners tomorrow.
- Effort Allocation: In non-asset intensive businesses, more than capital allocation, business strategy or effort allocation is something one needs to watch out. Take for example IT services. The areas where the respective managers focus today would mean how these companies look like 5 year hence.
- Management creates moat: While moats or competitive advantage rests on what kind of industry company is into, management has an important role to play depending upon the industry. Jockey and Rupa are the brands belonging to same industry but the return they generate on capital is widely different
- Management widens the moat: Having a moat is not sufficient. Eventually, there is a possibility that competition might be able to narrow the differences. What is more than important than having a moat is to understand that whether the management’s action deepening it further or actually doing the reverse i.e. filling it with mud?
- Sharing the rewards: Is the management (especially promoter-manager) privately taking up all the gains or are happily sharing them with their non-controlling co-owners. Lot of MNCs would fail this test.
The above points are by no way exhaustive but should communicate why is it important to not roll your eyes when it comes to qualitatively assessing the management.
But how should one go about it?
Let’s look at Buffett’s decision-making matrix.
Buffett has taught us to focus on what is ‘knowable and important’. That is to say focus on what matters and what we can possibly know about. No point worrying about unimportant or unknowable things.
When it comes to management’s evaluation, it sits in two quadrants.
It is important and hence would appear in the top boxes. It’s partly knowable and partly unknowable.
To the extent we have its past track record, we can study it and make a probabilistic assessment of its future track record (similar to pattern recognition). Its past track record is knowable & important while its future, depending upon the course of actions which management takes, is unknowable beyond a certain degree of probability.
If for some reason (takeover, succession, merger, etc) decision making were to change then it makes sense to study the history of this new decision maker. If that’s not yet available, it would be difficult and we could be early in terms of making an assessment based on limited history.
Factors to consider
Most of the things to consider would depend upon the context of industry it is into and its economic prospects. But some general things would be:
- Capital allocation: Invariably this is the first thing to consider. Where have been they investing over last 5-10 years? Is it diluting the existing core business or strengthening it? How does the incremental return on capital looks like?
- Leverage: Are they too fond of visiting their bankers frequently or they prefer to sleep well?
- Payout: Are they expanding the kingdom at cost of its citizenries?
- Equity raise: Do they frequently find themselves short of funds or they highly value their stake in the company?
- Private profiteering: Like making themselves and their relatives unduly rich at the cost of their non-controlling co-owners? Are they operating the ‘two-handled pump’ (deliberately reporting poor numbers to bid the stock down to aggressively buy shares and then do the opposite to sell it to the gullible public)
- Temperament: What do their comments in annual report, concalls tells you about their thought process – do they have the temperament to create long term wealth by delaying gratification or is it the reverse?
- Relative comparison: How have they being doing versus their close competitors – gaining business or giving its own business and making competition gradually dominant?
- Accounting: Do they like inflating their book earnings because they find it doing so in reality a bit difficult?
These are just some pointers. The aim is to avoid partnering with guys who, as Buffett says, cause your stomach to churn!
I certainly do not expect black & white answer post this type of qualitative assessment. But would surely try to avoid those deeper shades of grey whenever I come across it. Nothing stops the management to not repeat an adverse act unless there is an expressed, clear intent to not to do so again. But again, there are limits to which we can trust someone who has betrayed us once, right?
The more we align our thinking to that of a business-owner, the better served we would be in our endeavour to create wealth out of the market over our investing lifetime.